February 23, 2012
David R. Kotok
The issue of moral hazard came up three times this week. The first was during a discussion with Bob Brusca (http://robertbrusca.blogspot.com/). We dissected the development of the “moral hazard” and searched its history. Interested readers can find it under the phrase moral hazard on Wikipedia. The idea originated three centuries ago in the insurance industry.
The second occurrence was with my colleague Bob Eisenbeis. We were attempting to estimate what price differentials would occur in sovereign debt markets if European sovereigns adopt the policy of collective action clauses (CAC) in their debt issuance. The CAC is currently under discussion for implementation in the settlement with Greece. There is no history we can find of an active CAC. Bob and I agree that this is a serious issue; we suspect that its usage may grow beyond just one specific settlement with Greece.
The third discussion took place with Mike Dooley on Bloomberg Surveillance with Tom Keene and Ken Prewitt. Mike is a fishing partner and colleague on the BCA Advisory Board. Mike is also one of the preeminent scholars and experts in the area of moral hazard. You can find out more about Mike by visiting his home page on the University of California, Santa Cruz website: http://people.ucsc.edu/~mpd/.
Tom Keene allowed me to pose a question to Mike about CAC and moral hazard. Tom himself followed up on this issue. That audio can be heard at this link: http://media.bloomberg.com/bb/avfile/News/Surveillance/vhtixbU5BnC4.mp3. Mike’s view is that a sovereign debt pledge is a pledge that is either honored or not. His stance is from the policy perspective and arises from his role in the creation of Brady bonds during the Latin American debt crisis. Mike recalled that discussions took place about CAC at that time; however, the ultimate usage of that form did not occur.
Tom Keene and I each think this CAC proposal is a serious deal. We agreed to continue the conversation if and when CAC clauses are formalized and we can understand their terms.
In my view, the CAC is a new sort of moral hazard. It has the potential for damage to sovereign debt financing of all types.
Essentially, the structure coming out of Europe is something like this: there will be one type of debt in which the Greek government says, “We will pay and there will be no alteration or exception; we promise to pay, therefore you can accept that promise on the new terms of the instruments.” That type of debt is going to be held by the European Central Bank (ECB) and perhaps other institutions who are involved in this restructuring settlement of Greek debt.
The other type of Greek debt will have a legal provision saying that the terms of the debt can be changed retroactively under certain circumstances. That will be something developed by the Greek parliament and by the Greek government. In other words, CAC is the latest version of a deadly Greek gift. Watch out for it.
CAC represents an alternative in the restructuring negotiation that is fraught with risk. If a government can issue debt and maintain a method by which it can restructure retroactively, then that government’s promise is meaningless. It could do anything; it is clearly suspect. In the case of Greece, it is fully distrusted and absolutely suspect. The markets do not trust Greece; they have very good reason not to.
So what is the European leadership going to do? The economic structure of Europe now faces the issue of whether or not to allow a CAC to be implemented. I have personally been a long-time advocate of the European Union and the eurozone and all that has developed over the last two decades since the Maastricht Treaty came to be. The assumptions underlying that support are being undermined. Europe is now about to venture into a new form of Pandora’s Box. When it opens the clause of CAC, it opens it not just to Greece, but to other governments such as Portugal, Ireland, Spain, Italy, and elsewhere.
What will happen in markets if there is a CAC? Of course, we are speculating now, because we do not have market-based pricing to refer to. What we are about to discuss is a conjecture, an assertion. Let us think about it in a certain way: A government issues two types of debt: one with a CAC and one without. The market will say the pledge or promise without the CAC is stronger than the one with the CAC. The market will need to price these two forms of debt differently.
How will the market execute such pricing? Market agents will view the CAC provisions as an option. Furthermore, they will probably think about it as a put option held by the sovereign. In other words, Greece is the sovereign. It can change the terms of the debt structure. It can put the new terms to you and there is nothing you can do or say about it. If you want to adjudicate it, you are going to have to come to Greek courts and the Greek government in order to resolve any disputes.
Why should any international investor of any type purchase debt with a CAC issued by the Greek government, where the ability to adjudicate a dispute with the government of Greece is in the courts in Athens? You would have to be a nut cake to do it.
Readers are warned. The CAC is a very dangerous development in sovereign debt structures. It is a ratcheting up of moral hazard in a new form. In our view it is to be avoided.
We Americans have already seen moral hazard at work. We saw it in our banking system, where the federal guarantee of deposits provided funding that was misused. We saw it in the debt issuance of our GSEs that arguably had an implied federal guarantee. We have seen moral hazard throughout the world. We know moral hazard is a transfer of risk. And we know that risk transfer ends up as a cost to the taxpayers of a government (as with Lehman-AIG) or it issues from a government that is subsequently dishonored (Greece).
CAC is the newest version of moral hazard. We know that, at inception, moral hazard cannot be priced in the markets. As we learned from Lehman Brothers, a primary dealer of the Federal Reserve, moral hazard’s cost is only measurable after the fact. CAC is an acronym that may join LEH and AIG. Buyers beware!
As a matter of policy, Cumberland will avoid any debt structures that have provisions like CAC.
David R. Kotok, Chairman and Chief Investment Officer